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How Income Taxes Work

Tip: Refund Stats. The average refund during 2013 was $2,929.
Source: Internal Revenue Service, 2014

The Internal Revenue Service estimates that taxpayers and businesses spend 6.1 billion hours a year complying with tax-filing requirements. To put this into perspective, if all this work were done by a single company, it would need more than three million full-time employees and be one of the largest industries in the U.S.¹

As complex as the details of taxes can be, the income tax process is fairly straightforward. However, the majority of Americans would rather not understand the process, which explains why 60% hire a tax professional to assist in their annual filing.²

The tax process starts with income, and generally, most income received is taxable. A taxpayer’s gross income includes income from work, investments, interest, pensions, as well as other sources. The income from all these sources is added together to arrive at the taxpayers’ gross income.

What’s not considered income? Child support payments, gifts, inheritances, workers’ compensation benefits, welfare benefits, or cash rebates from a dealer or manufacturer.³

From gross income, adjustments are subtracted. These adjustments may include alimony, retirement-plan contributions, half of self-employment, and moving expenses, among other items.

The result is the adjusted gross income.

From adjusted gross income, deductions are subtracted. With deductions, taxpayers have two choices: the standard deduction or itemized deductions, whichever is greater. The standard deduction amount varies based on filing status, as shown on this chart:

Deduction Amounts

Itemized deductions can include state and local taxes, charitable contributions, the interest on a home mortgage, certain unreimbursed job expenses, and even the cost of having your taxes prepared, among other things.

Once deductions have been subtracted, the personal exemption is subtracted. For the 2013 tax year, the personal exemption amount is $3,900, regardless of filing status.

The result is taxable income. Taxable income leads to gross tax liability.

Fast Fact: No Pencil and Paper. The National Taxpayer Advocate reports that 29% of taxpayers use tax preparation software.

But it’s not over yet.

Any tax credits are then subtracted from the gross tax liability. Taxpayers may receive credits for a variety of items, including energy-saving improvements.

The result is the taxpayer’s net tax.

Understanding how the tax process works is one thing. Doing the work is quite another. Remember, this material is not intended as tax or legal advice. Please consult a tax professional for specific information regarding your individual situation.

  1. National Taxpayer Advocate, 2011
  2. National Taxpayer Advocate, 2011
  3. The tax code allows an individual to gift up to $14,000 per person in 2014 without triggering any gift or estate taxes.

As of January 1, 2013, an individual can give away up to $5,250,000 without owing any federal tax. Couples can leave up to $10,500,000 without owing any federal tax. Also, keep in mind that some states may have their own estate tax regulations.

The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. Some of this material was developed and produced by FMG, LLC, to provide information on a topic that may be of interest. FMG, LLC, is not affiliated with the named broker-dealer, state- or SEC-registered investment advisory firm. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security. Copyright 2014 Faulkner Media Group.

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